How to Read a Balance Sheet: Tips for Understanding Financial Statements
Small businesses can read their balance sheets to better understand the company’s accounts at a specific moment in time. To read a balance sheet, you need to analyze your business’s reported assets, liabilities and equity to get a clear picture of what your company owns and owes on a single date.
Here are the basics of how to read a balance sheet:
How to Read a Balance Sheet
To read a balance sheet, you need to understand its different elements and what the reported figures tell you about the health of your business. Here’s how to read a balance sheet:
1. Understand Current Assets
Current assets are items of value owned by your business that will be converted into cash within one year. Current assets include:
- Accounts receivable: these are short-term payments owed to your business, for example, outstanding invoices your clients will pay soon
- Inventory: for businesses that sell physical products, inventory includes finished products, in-progress products and raw materials
- Cash: includes checks, hard currency and unrestricted bank accounts
2. Analyze Non-Current Assets
Non-current assets are assets that can’t be converted to cash easily and won’t be converted within the next year. Non-current assets include both tangible and intangible assets.
- Tangible Assets: Include items such as property, machinery and equipment like computers and printers
- Intangible Assets: Are assets that aren’t physical by nature and include goodwill, copyrights and patents
Most non-current assets reported on a balance sheet are calculated with depreciation, which refers to the cost of the asset over its useful lifespan.
3. Examine Liabilities
Next in reading a balance sheet, you’ll need to understand the business’s liabilities. Liabilities are the financial obligations the business owes to someone else. Liabilities are divided into two types:
- Current Liabilities: These are short-term liabilities that must be paid within the next year, including accounts payable, payroll and current payments toward long-term debts.
- Long-Term Liabilities: These include debts, loans and other financial obligations due in more than a year from the date reported on the balance sheet.
4. Understand Shareholders Equity
Next on the balance sheet, you’ll need to understand shareholders equity. Shareholders equity refers to a business’s total net worth. It includes the initial sum of money an owner invests in the company. If a business reinvests its net earnings into the company at the end of the year, those retained earnings are reported on the balance sheet under shareholders equity.
How Does a Balance Sheet Work?
Balance sheets are divided into two parts. A balance sheet works by ensuring those two sides are equal to each other. The two sides of a balance sheet are:
- The business’s assets (debits)
- The business’s financial obligations (credits)
It’s called a balance sheet because those two sides must balance each other out. To ensure the two sides of your balance sheet are equal to one another, you can use the main formula of a balance sheet:
Assets = Liabilities + Shareholder Equity
Sample Balance Sheet
This sample balance sheet from Accounting Coach can help you better understand how to read balance sheets. It shows the layout of the statement, including the two sides that balance each other out.
If you are on the other end of the spectrum, we also have a sample balance sheet you can download and use right away.